Earnings Management and Manipulationby Scott McGregor

Earnings manipulation is usually not the result of an intentional fraud, but
the culmination of a series of aggressive interpretations of the accounting
rules and aggressive operating activities. The end result is misstatement of the
financial results perpetrated by people that had previously been considered
honest and may not have realized the severity of their actions until it was too
late.

The typical case of earnings manipulation begins with a track record of
success. The company or division has posted significant sales and earnings
growth over recent years. Their stock price trades at a high price earnings
multiple as the market rewards its stellar growth. Unfortunately, it is becoming
more difficult for the company to maintain the sales and earnings growth that
analysts have grown to expect. Sales are behind target this quarter, so
management runs special incentives for its sales force to accelerate sales and
uses overtime to ship out its products. It works and the firm meets
expectations.

The next quarter, the analyst expectations are higher. However, sales still
have not picked up to the level required, so the firm provides additional
incentives to its sales force, uses overtime to boost shipments but now has
additional expenses to contend with (incentives and overtime), so it does not
fully accrue all its consulting expenses. The following quarter rolls around and
sales still haven't recovered, but the analysts keep raising the bar. This time
the operating tactics are not enough, so management pressures the CFO to make
the numbers. The CFO is aggressive in the interpretation of installment sales
and expense accruals, and the company again meets expectations. The expectations
keep rising, as does the firm's stock price. As the fourth quarter comes around,
sales still are not at expectations. The CFO creates sales and under-accrues
expenses all to meet expectations. The company has gone from aggressive
operating practices to financial fraud.

Earnings management is the acceleration or deferral of expenses or revenue
through operating or accounting practices with the objective to produce
consistent growth in earnings. These earnings may not reflect the underlying
economics of the enterprise for the time-period. Some of the principle means of
managing earnings are "cookie jar" reserves, capitalization practices,
"big bath losses", altering the timing of operations to speed
recognition of revenues, aggressive merger and acquisition practices and revenue
recognition practices.

In general, the practice of earnings management leads to pulling operating
profits from subsequent periods creating even greater pressure on financial
managers to create earnings in those following periods. The management of
earnings can then lead to manipulation and misstatement taking management down
the path from questionable ethical practices to blatant fraud.

Some of the techniques used to manage and manipulate earnings are discussed
below:

a. "Cookie-jar" Reserves

The accrual of expenses is to reflect the period in which the expense was
incurred. For example, if a firm hires a consultant to perform a particular
activity, it should reflect the expense related to that activity in the period
in which it is incurred, not when the bill is paid or invoice received. In many
cases, the accrual of expenses, or reserves in particular industries such as
insurance and banking, are based on estimates. As such, the estimates have
varying degrees of accuracy.

During times of strong earnings, the firm establishes additional expense
accruals and subsequently reduces the liability to generate earnings when needed
in the future - pulling a "cookie from the jar".

In 1997, companies were allowed to capitalize the costs of internally
developed software and amortize it over the useful life, generally three to five
years. Capitalization is to represent the development costs. The capitalization
process of companies has the potential for manipulation because these assets are
often intangible and based on judgement. A firm may allocate more expenses to a
project that can be capitalized to reduce current operating expenses.

c. "Big bath" one-time charges

Unusual or non-recurring charges have become one-technique used by firms to
escape the maze of over aggressive accounting practices. Many believe and
anecdotal evidence has shown that analysts overlook non-recurring charges
because they are not part of the firms ongoing operations or operating income.
Typical non-recurring charges include writing down assets, discontinuance of an
operating division or product line and establishing restructuring reserves.

As discussed previously, firms practicing earnings management deplete the
economic earnings from future periods. As their ability to sustain earnings
growth diminishes, they may seek an event that can be characterized as one-time
event and "overload" the expenses attributable to that event. The
one-time charge may be discounted by analysts as not being part of operating
earnings while the stock price does not suffer the consequences normally
associated with missing earnings targets. To provide itself with more
"cookie jar" reserves or mask its past sins, the firm may take other
write-offs or create other accruals not directly tied to the event and attribute
those expenses to the one-time event.

A study by Elliot and Hanna (1996) reported that reports of large, one-time
items increased dramatically between 1975 and 1994. In 1975, less than 5% of
companies reported a large negative write-off compared to 21% in 1994. The
authors also showed that companies that had previously reported similar
write-offs were more likely to do so.

d. Operating activities

Managers often have the ability to modify the timing of events such that the
accounting system will record those activities in the period that is most
advantageous to management. The activity does not alter the long-term economic
value of the transaction, just the timing and thus, comparability of financial
statements. For example, a company could accelerate its sales and delivery
process such that it records sales in December that normally would have been
reported in January. Thus, the company reports higher fourth quarter sales,
revenue and profits. In the long-term, the company would ultimately report the
same sales and profits; however, it has inflated its growth in the near term,
and reduced profits in the future period.

e. Merger and acquisition activities

One type of significant event that may be used to mask other charge-off is
mergers and acquisitions. In most cases, there is some form of restructuring
involved creating the need for a large one-time charge along with other
merger-related expenses. The event provides the acquirer with the opportunity to
establish accruals for restructuring the transaction, possibly attribute more
expense than necessary for the transaction. The company may also identify
certain expenses that are revalued on the seller's balance sheet, increasing
goodwill. If the conservative valuations prove to be excessive, the company is
able to reduce its operating expenses in the near term by reducing its estimate
for the liability. The additional goodwill created would be amortized over a
long period of time and not have a significant impact on near term results.

There are two methods of accounting for mergers and acquisitions. Pooling of
interests ("pooling") accounting and purchase accounting. Pooling
recognizes the transaction as a merger of equals, thus the transaction is
recorded as company A plus company B. Purchase accounting treats the transaction
as a purchase. The fair value of the purchased company is assessed and compared
to the purchase price. Any excess or premium paid above the fair value of the
assets is recognized as goodwill. Goodwill is amortized over a period of time
not to exceed forty years.

1. Pooling on interests

Abraham Brilloff, professor emeritus at Baruch College, in an article in
the October 23, 2000 issue of Barron's entitled "Pooling and
Fooling" brought attention to the use of pooling accounting by Cisco
Systems to inflate its operating earnings. Cisco has been an active acquirer
paying $16 billion for twelve companies in fiscal 2000 alone, but through the
use of pooling accounting, Cisco only recognized only $133 million in cost in
its capital accounts for these transactions. In addition, five of the
acquisitions were deemed "too immaterial" to restate prior period
financial statements. Brilloff contends that Cisco's earnings for 2000 should
have been reduced by $2.5 billion reducing the $2.1 billion gain into a $.4
billion loss.

If a company pays a premium to acquire another firm, the premium, or
goodwill, is amortized and reduces earnings going forward. Thus, companies
seek transactions that will allow them to use pooling of interests. It has
been contended that additional premiums have been paid in instances where
pooling of interests will be allowed.

Criticism of pooling accounting has been significant and the FASB has
reacted by announcing the elimination of the method. However, the effective
date has been delayed as the FASB has received strong opposition from
industry.

2. Purchase accounting and goodwill

Under the purchase method of accounting for acquisitions if the price paid
by the acquiring firm exceeds the fair value of the company acquired, the
difference is recorded as an intangible asset, goodwill. Goodwill is amortized
over future periods, thus, the creation of goodwill causes future expenses,
therefore reducing reported earnings. If the acquirer conservatively values
assets (such as private placement or illiquid securities and real estate) or
liabilities (reserves, accrued liabilities), the company may be able to
recognize additional earnings in the near future as it estimates become less
conservative.

Professor Brilloff has also been a critic of the accounting practices of
Conseco, a financial services company. Mr. Brilloff contended that Conseco had
manipulated its earnings through its acquisition practices. In summary, he
argued that Conseco had inflated the loss or claim reserves of the insurance
entities it acquired and recognized a corresponding asset of goodwill at the
time of acquisition. It could then reduce the reserves over the near term to
inflate earnings while amortizing the goodwill over a significantly longer
period of time.

f. Revenue Recognition

The timing of the recognition of revenue is the most likely area to target
for management and manipulation. From an operational standpoint, firms can take
aggressive actions to boost revenues and sales in one period through providing
incentives to their sales force, utilize overtime to push shipments out the
door. They may also take aggressive accounting actions such as selling
securities classified held for sales recognize gains in income versus
stockholders equity, aggressive in the timing of the recognition of sales or
aggressive in the application of broad or unclear accounting guidance.

g. Immaterial misapplication of accounting principles

Materiality is a concept that has been under fire from the SEC due to its
misuse. As previously discussed. Errors, misstatements and misapplication of
accounting principles have been overlooked if they fell below the materiality
threshold. A company may knowingly misstate earnings by amounts that fall below
the materiality threshold by not correcting known errors or other misstatements.
If the practice continues for a number of periods, the balance sheet (retained
earnings) may become significantly misstated.

h. Reserve one-time charges

The use of one-time charges, established in the form of a reserve, can be
used to manage earnings. The company conservatively recognizes a one-time charge
in the form of a contingency reserve for a possible future loss or future
expense. They anticipate that analysts will discount the charge since it is not
deemed to be part of operating income. Over time, the company changes its
estimate (reduces) to recognize additional earnings.

In April 1998, Cendant announced misstated financial statements at its CUC
International unit, the announcement resulted in a loss of $14 billion in market
capitalization within one day of trading. Cendant had been a darling of Wall
Street until its announcement. It had produced a tremendous record of growth in
revenues and earnings. By April of 1998, the company was an active acquirer of
firms performing various services (Ramada, Coldwell Banker, Avis) and had
recently made news by outbidding behemoth AIG for American Bankers Insurance
Group, a deal that fell through following the accounting fraud announcement.

Cendant had acquired the CUC unit through a merger of equals. The firm had
two headquarters, one in Stamford, Ct. for the former CUC and one in New Jersey.
For the merger due diligence, Cendant had relied almost exclusively on the
audited financial statements of CUC. Thus, they failed to uncover the $ 500
millions of fraudulent sales and receivables recorded between 1995 and 1997, and
the million-plus of expenses charged by its CEO to the company.

The improprieties at the Cendant unit grew to the point where they could not
be concealed in its annual audit, prompting the announcement. Although Cendant
has survived, they sold 11 businesses and their stocks price and price earnings
multiple has not recovered. Cendant eventually settled the largest shareholder
lawsuit, $2.8 billion, in history.

b. Manhattan Bagel

From its initial public offering in 1994 to June 1996, the stock price of
Manhattan Bagel rose from $5 per share to $29. The company grew to be the third
largest bagel franchise in the United States with ambitious plans for
substantial expansion. Sales and earnings were growing. The company began to
expand through acquisition. In January 1996, the company acquired a West Coast
bagel operation, however, the firm failed to perform the necessary due diligence
and acquired millions of dollars of overstated revenues.

In June 1996, the firm announced accounting problems in its recently acquired
West Coast operations, and its stock price was cut in half within days. The
free-fall in its stock price continued and with the negative publicity and
shareholder lawsuits that followed, the company was unable to sell franchises at
anywhere near their previous pace. Eventually, the company was forced to seek
bankruptcy protection.

c. Sunbeam

Sunbeam, a maker of small consumer appliances such as Mr.Coffee, has drawn
much attention in recent years for its disappointing financial results and
cutthroat tactics of its former CEO, "Chainsaw Al" Dunlap. The
nickname was given to Mr. Dunlap for the manner in which he cut the size of the
employee base.

In mid-November 2000, the SEC concluded its investigation into accounting
practices at Sunbeam. The SEC charged that Sunbeam recognized revenues
prematurely from sales promotions with retailers in 1997. This activity was
prior to the dismissal of Sunbeam's infamous CEO, who was terminated in 1998.
Although not discussed in the SEC ruling, it would not be surprising if the
stress of the environment contributed to the aggressive revenue recognition.

d. Tyco

Recently, Tyco was forced to restate fiscal 1999 and the first quarter of
2000 due to certain merger, restructuring and other non-recurring charges,
increasing 1999 earnings and decreasing earnings for the first quarter of 2000.
Tyco is still under investigation for its usage of pooling of interest
accounting in its merger and acquisition activities. Based on the SEC ruling, it
appears that Tyco set aside "cookie jar reserves" in 1999 and began to
reduce the liabilities in 2000, thus, increasing earnings.

e. Sensormatic

Between 1994 and 1995, Sensormatic recognized out-of-period revenue,
overstating earnings to meet analysts' expectations. The Chairman and CFO had to
pay penalties of $50,000 and $40,000, respectively. Most likely, there were
quite a few individual investors who incurred greater financial losses as a
result of their actions.

f. 3Com

3Com agreed in November 2000 to pay $259 million to settle shareholder
lawsuits involving accounting irregularities following its 1997 acquisition of
U.S. Robotics Corp. 3Com had allegedly concealed losses at U.S. Robotics when
they combined the companies. Under pressure from the SEC, 3Com was forced to
reduce it stated net income for 1997 by $111 million and reduce a
purchase-related charge for 1998 by $158 million.

g. W.R. Grace

WR Grace & Co. was charged by the SEC with manipulation of its earnings
through the use of "cookie jar" reserves used to smooth reported
earnings in its National Medical Care Inc. unit.

The above cases are just a sample of some of the recent cases. These cases
display some of the circumstances and ways in which earnings can be manipulated,
including cases of blatant fraud, aggressive revenue recognition, cookie jar
reserves and inadequate due diligence in mergers and acquisition practices.